Op-ed

Post Crisis: What Europe Can Learn from the Baltic States

Of the several financial crises of the last two years, the most remarkable developments, for good or ill, occurred in the three Baltic States: Estonia, Latvia, and Lithuania. On the minus side, the three states experienced the most overheated economies within the European Union. They faced a nearly complete liquidity squeeze, which contributed to a total GDP fall of no less than 25 percent in Latvia and 17 percent in Estonia and Lithuania.

But there were positive outcomes too. These countries did not crumble. Social calm was maintained. Their democratic, parliamentary systems proved perfectly able to resolve the crises. Rather than devaluing, they pursued "internal devaluation," a process which required the Baltic States to lower wages and increase worker productivity. As a result, each carried out a fiscal adjustment of about one-tenth of GDP in 2009, mainly by slashing public expenditures and pursuing strategic reforms in public services. Latvia cut public wages by an average of 28 percent in one year. After two years, they have all returned to economic growth on the back of strong exports, and Estonia even qualified for adoption of the euro on January 1. Only Latvia required an international aid package, from mainly the International Monetary Fund (IMF) and the European Union, and after two years no further emergency aid seems needed.

Today, the Baltic countries can take satisfaction in the words of Walter Bagehot, the founding editor of The Economist: "The greatest pleasure in life is doing what people say you cannot do." They acted responsibly to resolve their crisis quickly and expediently. Their recent drama can act as a template for other countries, both about how to deal with the economics of a financial crisis and its political economy. There are seven lessons to be learned from their experience.

First, a choir of international economists claimed that the Baltic currencies had to devalue, but none did. It is now clear that devaluation was never necessary nor useful. They suffered from financial overheating because of excessive short-term capital inflows, while competitiveness was not all that poor. Their cure to overheating was to reduce capital inflows, which did not require devaluation. Moreover, the exchange rate parity forced the country to undertake long-overdue structural reforms. The general lesson is that depreciation is a much over-advertised cure in current macroeconomic discourse. The Baltic countries have a natural exit: the euro. Internal devaluation was a viable option, and it might have proven superior.

Second, the purported risk of a vicious, deflationary cycle was never real. For small and open economies such as the Baltics, prices are largely determined by the surrounding markets. Therefore the pass-through of inflation would be great, which means that devaluation would not have effectively enhanced the country’s competitiveness.

Third, the Baltic experience shows that both economically and politically it was better to cut public expenditures than to raise taxes. The most popular budget adjustments were salary and benefit cuts of senior civil servants and state enterprise managers as well as the reduction of public service positions. The Baltics have remained strongly committed to their flat income taxes.

Fourth, a strange myth has arisen that affluent democracies are politically unable to undertake large cuts of public expenditures. The Baltic countries have shown that their vibrant democracies were perfectly capable of cutting their public expenditures by about one-tenth of GDP in the first year of the crisis. Furthermore, these large cuts facilitated structural reforms, as they had to be selective, and thus not only reduced the capacity but often improved the quality of public services.

The fifth lesson learned was from Latvia, which has gone through four government changes in the last three years, changes that did not impede—indeed accelerated—the resolution of the financial crisis, which was delayed by a quarter from the anti-crisis program that had been adopted in December 2008. But the cause was hardly the ensuing government crisis, but the flaws of the incumbent government. The benefits of stable government have been much exaggerated. Many political scientists take for granted that political stability is good, but it is more important that a government is adequate than that it is stable; a pre-crisis government is rarely a suitable anticrisis government. Thanks to unstable coalitions, that dynamic could be swiftly addressed. Latvia could quickly, through trial and error, form a responsive government. The Baltic States show that advantages exist for sound macroeconomic policy when reforms of proportional elections lead to multiparty parliaments, coalition governments, and leaders who can respond quickly in a time of crisis.

The bottom line is that populism is not very popular in a serious crisis. The public understands the severity of the situation and wants a sensible and resolute government that can handle it as forcefully as necessary. Therefore, radical crisis resolution is likely to be a more successful political strategy in a time of economic trouble than populism, as shown by the victory of the Latvian government coalition in the parliamentary elections on October 2, 2010, and of the center-right parties in Lithuania two years earlier. The radical free-market government in Estonia sat safely throughout the crisis. Democracy has not impeded but has in fact facilitated crisis resolution. In this part of the world, free-market, center-right governments have never been stronger.

A final observation concerns the international macroeconomic discussion, which has been superficial and even harmful, indicating an intellectual and moral crisis. Whenever a crisis occurred, a choir of international economists claimed that it was "exactly" like some other recent one. Prominent economists led by New York Times columnist Paul Krugman claimed that "Latvia is the new Argentina." A fundamental problem is the inclination to accept a brief list of stylized facts without bothering to take into account the most elementary facts that distinguish one crisis from another.

Consequently, Estonia, Latvia, and Lithuania can offer Greece and other crisis countries in the eurozone lessons of radical internal devaluation, because for the European and Monetary Union members of the European Union, devaluation is not an option. Today, the Baltic crisis resolution exemplifies how it should be done: early, fast, and surgically.